Low-risk investors may prefer savings plans
Structure can be a useful tool. For many working adults, structure helps with prioritising important tasks when there are multiple "urgent" requests coming in simultaneously. Without a to-do list or timetable, it is easy to get sidetracked and neglect important long-term priorities.
The same concept applies to regular savings plans offered by financial institutions such as endowment plans. These plans can seem attractive and are supposed to help you save for goals, such as paying off your housing deposits and saving up for your children's university education. While we know these are our long-term priorities, many people often find themselves sidetracked from saving in the short term by unexpected discretionary expenses that might be hard to avoid.
By being locked into a structure with financial disincentives for early termination, these endowment plans make you less likely to raid the coffers or fail to contribute.
These plans might come with some capital guarantee as well, giving savers a sense of security that the contributed base will be unaffected even if the returns fail to live up to expectations. (For savvy price hawks among us, yes, this sense of security is false, since inflation would have eroded the base's purchasing power in the meantime.)
Why savings plans are less attractive nowadays
While these plans can be of some use, they are a rather primitive and blunt tool when we consider the alternatives. Optimal alternatives will not only have higher expected returns, but also provide flexibility to deal with unforeseen complexities without facing penalties.
From a returns perspective, what regular savings plans offer is quite paltry considering the strict limitations placed on the investor.
For a short-term savings plan, which requires an upfront contribution that must be untouched for 2 to 5 years, the rate of return is generally in the range of 1.2% to 1.5% per annum. Long-term savings plans (minimum of 10 to 25-year holding periods) may offer higher expected returns of up to 4.75% p.a., but these rates are not guaranteed.
In fact, even these illustrative rates are being lowered across the board by the Life Insurance Association, taking into account the sustained low interest rate environment. The projection of the investment returns have been revised down from 4.75% to 4.25% per annum and 3.25% to 3% per annum.
The actual return on these policies can vary widely, especially after taking into account insurance and investment related fees charged by the insurer and fund manager.
An investor who chooses instead to put his money in a safer measured portfolio of 40% equity funds and 60% fixed income funds for the same duration can reasonably expect a better return of 7.1% p.a. and potentially get a higher dollar amount than someone with a 20-year savings plan that are currently projected to get 3% to 4.25% before fees plus having the liberty to withdraw at any time.
From a practical perspective, the rigidity of regular savings plans can be detrimental to investors whose lives deviate from the simplistic assumption that life will be predictable and expenses unchanged for the next 10 to 25 years.
If the global pandemic has taught us anything, economies can grind to a standstill and jobs lost overnight. Expensive health issues can arise suddenly and devastatingly, and there are some life goals - starting a family, moving countries, etc. that can significantly change our expenses.
An investor who can no longer contribute to their institutional savings plan can end up in the red when surrendering their policy, even in so-called "capital-guaranteed" plans. Even those who have managed to contribute fully but cannot wait for the end of policy to collect the maturity value due to life circumstances will likely have to forfeit a sizeable sum of their hard-earned capital.
So what can you do to create a more cost efficient, withdrawal-penalty free, savings plan?
Making a DIY short-term savings/endowment plan
Given the plethora of investment platforms on the market today which are easy to use, readily available and low-cost, there is very little reason to stay tied down.
For short-term savings goals, you may be better off using cash management products which can potentially give you comparable returns to a traditional savings plan while providing flexibility when deciding how much and how often to contribute. The probability of loss in cash management portfolios is not zero, but is generally low enough even for the most conservative savers.
For example, our Cash Smart Ultra portfolio, built using low-volatility money market funds and short-duration bond funds, provides investors looking for better returns with an attractive vehicle to park their money in with projected returns of up to 2%.
Making a DIY mid/long-term endowment plan
For long-term savings goals, the investment horizon usually means that a portfolio of equity and/or fixed income funds can be suitable and are likely to beat the returns offered by institutional savings plans.
While volatility of returns can be a factor when investing in equity and fixed income funds, using a platform that automatically rebalances holdings back to match the objective allocation set up can help investors manage volatility. Additionally, the ability to shift asset allocation from a more aggressive equity-heavy portfolio to one that is more conservative closer to your withdrawal date can help to manage volatility without leaving returns on the table.
In both cases, you can still rely on structure to prioritise saving by setting up an automatic recurring bank transfer and investment order. Automating the act of depositing and investing can take away the temptation to redirect it to discretionary expenses at the spur of the moment, to the detriment of saving for your life goals.
Flexibility is key to a DIY savings plan
It is sensible to still use structure to help prioritise limited financial resources, but this shouldn't be so rigid that it cannot bear change without causing significant losses. We can probably all agree that it is absurd to turn down an exciting work opportunity just because it is outside of your to-do list, or to never redesign your daily routine when it no longer fits your circumstances.
Wouldn't the same apply to your savings too?
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Next on the Endowus Fin.Lit Academy
Read the next article in the curriculum: Are you saving too much cash? The real cost of staying liquid
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